Contractor Insolvencies and the Risks to the Owner/Developer
A retail construction project illustrates the risks to an owner when the general contractor encounters financial problems. As is typically the case, the general’s financial troubles started when he got behind in payments on earlier projects. As a result, the initial payments on the retail project went to pay subs and suppliers from the earlier projects, which in turn, of course, left subs and suppliers on the retail project unpaid.
This game of catch-up worked for a brief period, as do most Ponzi schemes, but during that time, the problems only compounded themselves. Not only were subs and suppliers going unpaid, but the general was also spending less and less time supervising the project and more and more time dealing with his increasing financial troubles. Among other things, the distractions caused him to fail to get signed subcontracts. Work-quality issues became common, and, in the absence of written subcontracts, change order disputes became difficult to resolve.
The owner paid the monthly draws timely, but was lax in monitoring the collection of lien releases. The general began using the owner’s payments to cover obligations from other projects and even to pay personal financial obligations. Eventually, the subs and suppliers started filing liens, and it was at this point that the owner first realized there was a problem.
The owner retained an attorney to deal with the liens and investigate claims against the contractor. In fairly short order, the contractor was terminated, which resulted in the project slowing to a halt and ultimately led to a completion delay of several months. These conditions placed the owner in default of its bank loan.
The owner’s expenses and losses included multiple items: (i) paying several of the subs and suppliers amounts that had previously been paid to the general; (ii) paying attorney fees and 18 percent interest to discharge multiple liens from the property; (iii) hiring a replacement contractor at a fee significantly greater than the amount remaining in the prior general’s contract; (iv) paying the bank’s attorney fees, along with default interest; (v) paying its own attorney fees; and (vi) responding to legal claims from preleased retail tenants who were delayed in moving into the project.
In the end, the owner’s cost overruns very well may force it into insolvency and it may, as a result, end up losing the project. While the owner certainly has claims against the general, they likely have no value in light of the general’s insolvency.
The owner could have done a number of things to prevent these problems. First, it could have investigated the contractor’s financial condition before even contracting with it. An investigation might have involved looking at the contractor’s financial statements, speaking with the owners of the contractor’s most recent projects, and ordering a Dunn & Bradstreet report. Second, the owner could have insisted on receiving lien releases from subs and suppliers as a condition to paying the general. While these steps are not foolproof, and while fraudulent tactics can be used to undermine them, a cautious owner can do a lot to avoid the problems that can result from a contractor’s insolvency.
Owner/Developer Insolvencies and the Risks to Contractors
Developer insolvencies are unfortunately becoming more and more common in our current economic climate and often result in partially completed projects being stopped. The consequences to contractors can be significant. A number of recent resort projects illustrate what the contractors and subs can typically expect.
First, the obvious, immediate problem is nonpayment, which in turn requires the contractor to file a lien. After a lien is filed, the contractor has 120 days (in Oregon) to file a lawsuit to foreclose it. The commencement of the foreclosure suit is only the start of what can sometimes turn into a long and drawn-out battle with an uncertain outcome.
If the project involves conventional bank financing, as many do, the biggest battle will be between the contractor and the bank. If the contractor has prepared its lien properly (and mistakes here are common), it will normally have priority over the bank. While in some cases the contractor may be successful in moving the case along quickly, it 's not at all uncommon for such cases to drag on for a year or more, and this will likely be the situation if there are significant priority disputes.
In other economic climates, banks would often step up and pay off the construction liens, once any priority issues were resolved; however, that is not happening as often in the current climate for a number of reasons. First, many banks are dealing with their own insolvency issues, and some are operating under Federal Reserve supervision. Banks in those situations are often incapable of advancing new funds. Second, as a result of the recent significant decline in real estate values, the equity cushion that many banks thought they had when making the loan has disappeared. Absent having any equity to protect, many banks will simply elect to abandon their collateral to the construction lien claimants. And third, participation loans have become more common, with the result that the lender on a particular project might not be an individual bank, but instead a collection of banks, perhaps as many as 40 or 50. Negotiating with a single entity presents a different dynamic from negotiating with a committee.
In the course of the lawsuit, the contractor is obligated to the subs and suppliers. If the subcontracts contain pay-if-paid or pay-when-paid provisions, the general contractor may be protected, though not necessarily. Recent case law has held that a pay-when-paid provision still obligates the general contractor to pay subcontractors within a reasonable period of time and does not permit the general to delay subcontractor payments indefinitely.
Assuming the general succeeds in being awarded a judgment in the lawsuit, the next step is to schedule a foreclosure sale, and this can be done within approximately two to three months after a judgment is entered. If the bank has not stepped up and paid subcontractors by the time the foreclosure sale is scheduled, there is a good chance that it will not do so and will instead allow the sale to go forward. If the sheriff’s sale takes place, the bank is still protected, because it can later exercise its redemption rights to acquire the property for the amount that was bid at the sale.
However, if the owner believes there is equity in the project, and most owners are optimistic that there is, even in the face of an appraisal to the contrary, the owner will file a bankruptcy petition in time to prevent the sale. If the owner is a single-asset limited liability company, which is how many development projects are set up, a bankruptcy filing is an easy decision. Typically, the owner will wait until only a day or a few days prior to the scheduled foreclosure sale to file the petition.
In bankruptcy, the owner will likely propose a plan of reorganization that involves delaying completion of the project for a few years until the economy turns around, which will, in theory, give the owner time to locate new financing, complete the project, and pay everyone off. All of this, of course, means three, four, or maybe five years of delay in the contractor getting paid. Many contractors simply cannot wait that long.
The contractor can do a number of things to prevent this situation from happening. First, the contractor can investigate the owner’s financial condition before starting work. This might involve asking for financial statements, requesting confirmation from the lender that the financing has been approved, and ordering a Dunn & Bradstreet report. If there are concerns, the contractor should request that the owner post a payment bond. Second, the contractor should include strong language in the contract allowing it to stop work for nonpayment and to demand financial assurances in the event it has reason to question the owner’s solvency. Third, assuming that it has included strong language in its contract, the contractor should exercise its right to stop work promptly in the event of nonpayment. Fourth, the contractor should insert pay-if-paid provisions in its subcontracts. And finally, the contractor should act promptly and cautiously in filing its lien.
More than anything else, payment defaults can cause contractors significant delays. Anticipating payment issues at the contracting stage and monitoring the issues closely during performance are critical.
